Saturday, December 17, 2005

(P.S: Sorry for any disturbances the advertisements above may have caused you)

Main issues

1.High valuation - >20X trailing PE

2.Limited business moat; it may not be difficult for new players to complete qualification process

3.Potential over-supply situation

The recent favourable coverage of Midas by BNP fuelled its surge from the mid-30s to the mid-40s. Midas was cast as a play on the booming infrastructure sector in China, in particular the rail transport sector for which massive investments were supposedly being planned by the Chinese government.

One must put things into perspective; any sector in China nowadays can easily be portrayed through rose-tinted lenses. We have seen Zhongguo Powerplus cast as a play on the increasing governmental support of the agricultural sector, China Flexible Packaging as a play on the booming China consumer market, China Paper as a play on the growing need for paper as a basic material for various China industries, Junma as a play on the China automotive sector. Yet where is the previous optimism surrounding these stocks now? Analyst coverage pushes the stock up, potential is highlighted while risks are ignored, and when the latter surface (as did the weather risk for Zhongguo Powerplus recently, corporate governance concerns for CFP and China Paper, debt and profit margin concerns for Junma), optimism fades and the stock price and ultimately liquidity die a natural death.

To be fair to Midas, as a Singaporean company in spirit (given the origin of its founder Patrick Chew) it deserves a better valuation than the abovementioned. This is what investors have come to realise after the events of the past two years, not just CAO but also the string of China IPOs whose profits seem to evaporate after getting themselves listed on the SGX. Yet look at its valuation now: 22 times trailing PE and probably still 20 times forward PE, given its average growth this year. And I don't think it has much of a business moat, being merely a manufacturer/supplier of aluminium products.

Midas' business is now split (revenue-wise) 66-33 between its aluminium alloy division and its PE pipes division. Let's do a short analysis of the former, which BNP has portrayed as the growth driver, in particular for the rail transport division. Consider Porter's five forces industry analysis model: buyer power, supplier power, competition, the threat of substitutes, barriers to entry. If growth is going to be driven by demand from rail transport, it appears Midas' existing relationships with incumbent customers Siemens and Alstom, for which it has been prequalified, is going to be increasingly important; buyer power might drive down margins. According to Midas' IPO prospectus, ~70% of their aluminium raw material is sourced from two factories in Fushun due to physical proximity; however given the abundance of aluminium suppliers supplier power is weak; that's good for Midas. I'm not so clear on threat of substitutes, but it appears to me that if high-speed trains were to mirror that of the development of aircraft ie. the emphasis on weight, composites may well be a strong competitor. And not to forget the competition that the much cheaper conventional rail offers high-speed rail; the latter is the strength of Midas' customers but one should note that the Beijing-Shanghai line was the subject of much debate about the use of conventional (steel carriage) vs high-speed (aluminium carriage) rail which has still not been resolved. The last two factors are what I would consider the greatest impediments to Midas' growth: China is well-known for drastic over-investment in response to initial demand, especially in basic materials; one only has to look at how the steel industry swung from a position of deficient supply to over-supply within a period of <2 years and its impact on incumbents on our very own HG Metal to get a feel. It is not that difficult to get into the aluminium alloy industry; Midas' preferred supplier status with Siemens and Alstom are competitive strengths but I wouldn't believe that the qualification process for new aluminium alloy suppliers would take long. Tell me, what kind of "high degree of precision and consistency" is required to produce "an aluminium alloy profile measuring 28m by 0.7m", as claimed by BNP in their report? I don't think metals suppliers are typically considered strategic partners in the supply chain of a transport platform, and as such it should not be difficult for new players to enter the fray.

The same applies for its other business division: PE pipes. Again the story is of lack of business moat in what is essentially a commoditised industry.

I am generally bullish on the China infrastructure sector. But if we were to peg its growth to China's GDP growth (in order to be sustainable in the long term) it probably would experience something like 10% a year. The transport industry is a priority for the China government, and might grow faster than that, but surely at >20 times trailing PE Midas is trading at close to fair value, if not above? We are all factoring in the future growth prospects, but forgetting the key risks. To put it another way, the market is pricing in the expected strong demand for its products, but ignoring the expected strong growth in corresponding supply stock from its competitors.

7 Comments:

anonymous,To be frank, Cosco is one of those stocks that I might have to reverse my bearish position on. It has performed as predicted (ie. very well) and given the growing China market and its comparative cost advantages, I am getting quite impressed.

It has been correcting downwards these few months: that was a result of its high valuation factoring in all the good news. If it continues to do well for FY05, it might be worth buying.